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Physicist, Startup Founder, Blogger, Dad

Tuesday, December 25, 2012

EMH vs Macro, Fischer Black

Arnold Kling on the tension between macroeconomics and the Efficient Markets Hypothesis (EMH). I'm surprised this isn't more often noticed by economists. But I suppose macro types don't tend to think deeply about finance (at least, not before the recent crisis; how many macro types actually understand Black-Scholes-Merton?) and vice versa. I was shocked at the beginning of the credit crisis to meet famous macroeconomists who didn't know what a credit default swap was, and I still often meet finance types who laugh at macro models.

askblog: Consider financial variables, such as the long-term interest rate or the price-earnings ratio of the overall stock market. According to the efficient markets hypothesis, these are not predictable on the basis of known information. To put this another way, you cannot beat the market forecast for these variables.

On the other hand, in conventional macroeconomics these variables can be predicted using models and controlled using policy levers. Reconciling this with the EMH has challenged economists for decades. ...

I prefer a third way of looking at things, which might be expressed in the work by Frydman and Goldberg. That is, there is no reason for all participants in markets to be using the same model. They have different information sets. The EMH is a useful guide to everyone, because it serves as a reminder that it is unwise to assume that your information set is somehow superior. However, it is not correct to impose “rational expectations,” in which everyone uses the same model.

... Incidentally, I recently re-read Perry Mehrling’s biography of Fischer Black. Black was perhaps the first economist to think about the contrast between modern finance theory and conventional macro, and Black was the first and perhaps the only one to attempt to recast macro entirely in terms of modern finance.

More thoughts on EMH here. My comments on Mehrling's bio and Fischer Black are here.

... on the topic of finance books, I highly recommend this biography of Fischer Black, which I should have reviewed here long ago. Fischer was yet another outsider (his background was in theoretical physics) to finance who made an important contribution. Unlike Kelly, he was accorded mainstream recognition (professorship at Chicago and partnership at Goldman) during his career. The most impressive thing about Black was his ability to think deeply and independently -- beyond the conventional wisdom. There are some very intriguing passages in the book about his views on money and banking which are, I think, quite unconventional to mainstream economics.

... Black was both an undergrad and grad student at Harvard in physics. He didn't really complete his PhD in physics, but sort of drifted into AI-related stuff(!) at MIT, under cover of math or applied math.

The bio says the only course he ever had trouble with was Schwinger's course on advanced quantum. The biographer suggests Black did poorly due to lack of interest, but I find that hard to believe given the subject matter, the lecturer and the times ;-)

Black's point of view was clearly that of a physicist or applied mathematician. He really was a fascinating guy, and the biographer, being an academic economist, can appreciate a lot of Black's thinking -- it's not an entirely superficial book despite being non-technical.

After reading the book, I don't feel so bad about questioning some of the fundamental assumptions made by academic economists. Black was asking some of the very same questions during his career.

22 comments:

SethTS
said...

I recommend Black's essay "Noise": http://www.e-m-h.org/Blac86.pdf

The ocean would be flat if the earth did not rotate, have a moon, etc. The Earth's gravitational field is clearly a big contributor to the total forces on the oceans, but it won't predict its behavior well because it is far from the whole story. EMH asserts a sort of martingale condition on the time series of asset prices. It captures an important characteristic of highly liquid markets in short periods with no 'news' -- or other changes in traders' risk assessments which would alter their preferences among assets.

EMH is a joke. The inability of most people to beat the EMH is another story it says something about very poor ability of people to:

1. objectively weight the available information about the whole system2. quantify the probabilities for events. For example, you can be very knowledgeable about some sport, and you might have a very deep understanding about the conflict of two teams, and you might say that team A is a favorite because of (x1 ... xn) things, but you'll have a huge difficulty answering a question "what's the probability that the game will be won by team A, B or draw?". To humans probability of 60% or 75%, doesn't look all that different, and we make even bigger mistakes.

When we combine all this together the whole market in the long run behaves irrationally. People who are better in understanding 1. and use some objective way to better quantify the 2 will beat the market without much problems.

I think this is an awfully broad overstatement. Modern empirical finance has done work with a 'finance' view, and it is not a small amount. John Cochrane wrote his book 'Asset Pricing' at the beginning of the last decade, and advocated strongly the predictability of returns over longer time frames based on a multitude of macro factors. Even Fama himself has done plenty of work on the predictability of returns. Cochrane also realizes that these predictive measures only have very limited data points with which to verify their power, and states that (and this is approximately 2001) that the next decade of returns would have to be meager in order to 'restore the regression'.

It isn't fair to ignore the large amount of empirical work that has been done since the EMH wasn introduced long ago, especially considering that many of its many advocates have been updating their priors in the wake of new data, and this was prior to the crisis. None of this is to downplay Black's creativity, but it is important to realize that Black had a large influence on Fama, and so did the esteemed Benoit Mandlebrot. Fama gave a recent interview where he said Black was one of the only people he met who often made him question his own beliefs, and change his mind. I think Fama gets far too much criticism given the quality of the work he has done since what made him famous, work that is largely ignored by his critics.

"It seems to me that the market monetarists (e.g., Scott Sumner) believe something closer to (2) than to (1). But (2) can get you into some strange conundrums. Does the Fed have free will? That is, does it have the ability to surprise markets, other than by acting randomly? If its actions are not random, they should be anticipated by markets. If they are anticipated by markets, then they should have no effect. etc."

Kling says this like it's some paradox, but it's not. Fed policy can easily affect equilibrium market prices without "changing them". Imagine the Fed tries to make Nominal GDP level (or price level) travel along a growth path of 5%. Everyone know's what they're trying to do. They're pretty successful at this. This affects financial market prices since obviously if the Fed did not exist the NGDP (or price) level would be different and that has effects on market prices. But at no time are market prices "changed" since there's no news, no one has to react to changes in Fed policy since they don't change it. Nothing paradoxical about it.

* Fischer Black: interesting, thoughtful, original guy. We need more like him.

* Macro and finance. There's some specialization, to be sure, but lots of people know both macro and asset pricing, including several recent Nobel prize winners. In most modern work, quantities (macro) and asset prices (finance) come out of the same model. The connection isn't new (supply and demand?) but I think it's been really fruitful, because you have multiple perspectives on the underlying structure. Think, for example, of the sharp increase in risk spreads in late 2008, which predate the decline in GDP etc. No question, though, that there's lots more work to do.

* EMH: what on earth is Kling talking about? He says: "Consider financial variables, such as the long-term interest rate or the price-earnings ratio of the overall stock market. According to the efficient markets hypothesis, these are not predictable on the basis of known information." You might find quotes from the 60s or 70s saying something like this, but the modern interpretation, I think, is simply that information is reflected in asset prices. That still leaves things like risk premiums to move around in predictable ways. There's no end of working trying to do this in both finance and macro. I read the whole post (Kling's, I mean), and with due respect to his offer to "take the most charitable view of those who disagree," I'd have to say the post is more confusing than helpful. Is that charitable enough, or do I need to work on it a bit more?

hmmmm, I totally recall that lots of people dislike EMH because they think the market is easy to beat, but beware making such a statement unless you are directing all the cash in that you wish to direct ... now, as Dr. Hsu will remember we spent many a weekend in Las Vegas proving your point, but we the scale seemed to be limited to hotel rooms, prime rib, all you can eat (unpeeled) shrimp, free show, and unlimited drinks .... but it gets tougher to prove you point when the stakes grow ... not sayin' you wrong, just sayin' ....

I'm not saying market is easy to beat for an individual. I'm saying that the EMH claim that the price of a stock is a reflection of all available information and that there is no way to give a better assessment, a joke. It's a completely another thing why most people give even a worst prediction of a market. Look for example at the housing bubble, everyone (well, not everyone) was delusional that the prices of houses must go up forever. Reason for this delusion is in human mind that gives terrible predictions and assessments of a risk, not that information was not available.

Look at another example, when Steve Jobs gave a talk at one of his last conferences, the stock price rapidly went down, because he looked terrible, a few days when the claims were disputed price went up again, after his death the price of stock had a record high (and now its falling again). Now tell me this is a rational assessment of a core business of Apple in the long run.

Hauser - if that is your understanding of EMH, then you are about 40 years behind current practitioners. If you want a good overview of the modern empirical work that has been done, look at Antti Ilmanen's Expected Returns. The book has a lot of breadth, and if you want to go into depth on any of the topics he covers, he provides the underlying papers for those who'd like to understand the methodologies in practice today. Plus, Antti has the additional stamp of approval in that he is an investor in the markets, working at Brevan Howard, and not just an academic.

I assume you are not a money manager. Are you convinced of the great difficulty of beating the market for fear of leaving your gilded cage or vice versa? What holds a GS partner back from starting his own shop?

I don't think it's only few individuals that can beat the market, if you're referring to someone like Warren Buffet, of course, that's true, but there are people that have solid gains over the years, nothing spectacular, but beat the markets on regular basis (although in many cases it could be pure luck).

As in everything, if you want great gains, the time you need to invest becomes significant. Most people are not ready to invest that much time as it's less risky to peruse a standard path (or just don't want to), where you invest your time in getting a degree, finding a nice job and perusing promotions. Don't interpret this as "if someone invests enough time he'll beat the market", it's only one of necessary conditions not the only one.

The point is, there is nothing fundamental that would stop you from beating the market if you have the skill and invest enough time.

To cover some basics - if the market is the sum total of all investments, they the average performance of all investors must be that of the market. Next, large diversified funds are available cheaply that will pretty much guarantee a market outcome. Thus, the group of individuals seeking to beat the market are playing a zero sum game. So, I agree people can beat the market, but only by identifying the "negative alpha" and trading against it. This is a kind of limiting factor in how much can really be made. There is also an important role for public policy to play in protecting people from employing delegates who will land them with that negative alpha ...

For gide07, I think the book "The Hedge Fund Mirage" by Simon Lack is good and is very well researched. You have no need to beat the market to get rich as an "investor" if you can get 20% of other people's upside and none of the downside. That, of course, is the biggest source of negative alpha of all.

Buffet, if I dare opine on him, does best when he is taking advantage of his size to achieve outcomes which are not available to the broader market. The boards of directors of joint stock companies are supposed to be representatives of the owners, but at most companies they are just selected by the CEO and, in fact, rarely have meaningful ownership stakes. If you can buy a chunk of the company and name some directors however, now you can really add value. But, IMHO, the Buffet's of the world probably would not outperform if they had to invest like a "normal" person does. In other words, his investing actually creates the value he reaps, rather than him having to rely on negative alpha. So, I don't consider him an investor so much as a "captain of industry" if you will ...

Your description of Buffet's mo is false. and it surprises me coming from you. '"captain of industry" if you will' describes people like Icahn and KKR, LBOmeisters and greenmailers. Berkshire became mostly an "operating" company only 10 y ago IIRC, and Buffet has always been hands off of his investments. He may be or may be on occasion hands on for those cos Berkshire owns outright, I don't know. The EMH is subscribed to by professors for "psychical" needs. I suspect the same is true for quants.

Well, the wikipedia (at this moment) calls him a "business magnate" first and "investor" second (and philanthropist third!) - how about business magnate instead of captain of industry? Maybe we don't disagree? I apply EMH to ordinary Joe Blow's, but Buffet started his career as the only son of a U.S. Congressional Rep. - and he has never left that congressional district! If you think his investing success was solely due to his skill ... well, to quote the Godfather, "Oh, who's being naive, Kay?" Check out Michelle Obama's brilliant career as a director of TreeHouse Foods - how did she get that job? ... If you are local to NYC or London, we can tip back a scotch or two, and then you tell me if I have unmet "psychical" needs ... The unexamined life is not worth living ...

Not much that you say here that I object to, though I think much of it is complementary rather than contradictory to my points. When investors opt into the zero sum speculation game, some will win and some will lose - and along the lines you lay out, it won't be random, the skilled will win the unskilled's money - but it is still a tough zero sum world. And I don't even disagree with what you say about Buffet as long as you would agree that having your father as your congressman confers a huge advantage to a small scale investor and that once having obtained scale there are non-linear advantages that accrue from turning ones investing from passive to non-passive involvement in the companies. I will add that getting involved in the investments is also a hallmark of David Einhorn.

Of course, a weakness is my argument is that if some great natural athlete of investing came along, they would accumulate capital to a scale where my "non-linear get involved in investments " lines would apply, right? Not much I can do to defend against that. However, if I understand you correctly, you believe the Buffet profits by choosing better investments than the other speculators, and thus he creates a whole lot of negative alpha out there ...I sure hope pension funds and endowments aren't on the other side of that ...

And a billboard on the road to Galt's gulch says, "Wall Street and entertainment types proceed further at your own risk." Buffet et al are d-bags, but quants are pushing the "technology" of finance forward. Who's flattered?

Ouch, so harsh on the psych types! Let's assume they can't help us.How should I tell whether my belief in it being difficult to beat the market is an honest result of my knowledge and analytic skills vs. being the answer to a psychical need presumably based in my fear to try my skills against the market? The eye sees not itself .. help me out here ...

Even model minority Steve has admitted that when Ed Witten drops trou he cries.

Given the same "knowledge and analytic skills" do you see any inefficiencies? Do you expect such will persist? If not then .... maybe ... hmmm .... "not have way". Even if PTJ, Soros, etc. are idiots or cheats there is still alpha "sitting out there waiting to give you their money" 2:18, especially in the rarefied space of illiquid derivatives.